The real estate boom in China (2005-2012) has led to 10% growth or more per year and high employment. The year 2013 has been the beginning of a new period. This new period is also characterized by the new leadership takeover by Xi Jinping and Li Keqiang who are keen to implement structural reforms to make Chinese economy back on a sustainable track. Everyone closely monitors the new leadership actions to overcome China challenges. As the chart below shows, China has to get prepared for a drastic slowdown of its economy as it is moving away from an investment-led economy to a more consumption-led economy, a shift that has been advocated for years by previous leadership and scholars in China and abroad. This necessary shift will take years to be fully implemented but the new leadership is expected at least to initiate the move and handle the transition.

Investment-transitions-chartAfter the peak of investment (share in GDP), GDP usually falls by 50% or more in Asia.

In November 2013, the third plenum (the third time new leaders of China lead a plenary session of the Central Committee) was held. Plenum generally takes place a year after new leaders take office, after they have established their power base. Previous Third Plenums have had a major impact on China’s development: for instance, at the Third Plenum in 1978, former leader Deng Xiaoping announced the opening-up of China’s economy, spearheading major market-oriented reforms. More recently, in 1993’s Third Plenum, Zhu Rongji announced the “socialist market economy” and dismantled a large part of SOEs. Below are the key features of November 2013 Plenum:


First of all, it is important to acknowledge that all of these reforms go in the right direction. It seems that the Chinese leadership is well aware of the necessity to implement reforms needed to keep the country in an economically and socially sustainable path. However, there are some concerns about these reforms:

  • Analysts remain sceptical about new property tax (price up by 20% y-o-y in Tier-1 cities)
  • There are no strategies or no tools to handle rising shadow banking risks, including bad loans, risky financial products, or local government financial platforms
  • Reforms are going to be gradual, despite imminent risks of housing and credit bubbles

These three points will be developed below later on. For now, let’s take a look at some figures and trends:


These two charts clearly show that Chinese leaders don’t have much time. A tradeoff has to been determined between gradual and “therapy shock”  to implement new reforms. Why? because there is an urgent need to cut corporate debt fueled by shadow banking (the alternative financing channels, regulated but more risky than traditional ones). Some business have to fail, otherwise corporate debt will continue to be rolled-over and sky-rocket especially in sectors plagued with over capacity.

Culturally, it is difficult to acknowledge a failure in China (??). Indeed, there are theories proposing that the long work out in Japan in the 1990’s was due to the same cultural issue. But more importantly, one bankruptcy might trigger other failures due to systemic risks, eventually leading to a financial crisis and even financial collapse. Chinese economy is not strong enough to overcome a financial crisis right now given its own issues and weak worldwide economy. The Fed exit strategy engaged in December doesn’t help either.

Real estate situation in China

In recent Chinese economic history, real estate has always been one of the only available way for Chinese household to at least hedge against inflation and potentially enjoy an actual real return on their savings. In addition, owning a house plays a major cultural role, with emphasis on ownership, which very often is a condition to get married.

On top of it, Chinese households cannot freely send money abroad and deposit rate have been periodically below inflation. Besides bank deposits, there are only few available alternatives for savings: Chinese stock markets are unreliable, marred with insider dealings, and have performed poorly since the 2008.

As a result, real estate is the only alternative. In Beijing, there are currently 6,000 super landlord, each of them holding more than 300 apartments. Despite measures, all of these factors have always put high pressure on property price in China. Why would it be different this time?

Shadow Banking situation in China

Kenneth Ho

Historically, the supply of credit in China has been channelled mostly via the banking system. But over the past five  years, we have seen rapid growth in credit from the non-bank sector, or the so-called “shadow banking” sector. In 2012 shadow banking credits accounted for 24% of the total credit balance to corporate and consumers (but 39% of  the flow of new credit that year).

In comparison, the liabilities in the US shadow banking sector are similar in size to  liabilities of US commercial banks. However, the pace of shadow banking growth in China and the opacity of the  products means that it provides a source of latent risk. For more details, have a look at Ning Ma’s February 26, 2013 report entitled ‘Casting a light on shadow banking.’

  • How to define shadow banking in China ?

There is no formal definition of shadow banking in China,  but a common understanding is that this encompasses credit exposures that are sourced from outside of the formal banking system. This does not mean that these types of lending are unregulated or uncontrolled, although some segments do carry higher risk. Adopting this definition means that shadow banking incorporates the following types of lending:

Corporate Bonds: While this is often included in the classification of shadow banking, it is (relatively speaking) a better regulated and more transparent area, with positive selection bias in that only the better credit quality companies (non-Local Government Financing Vehicles -LGFV thereafter) are able to issue corporate bonds with low funding costs. Three regulators (NDRC, CSRC and PBOC) each regulate a sub segment of the corporate bond market.

Trust Loans: Trust companies can use trust funds to extend a loan to a corporate (LGFV or non-LGFV). The corporate provides a guarantee on the trust loan and/or collateral to the trust. This is regulated by the CBRC. There is no recourse to the issuing trust company. Trust products are typically sold to high net worth individuals and professional investors. The incentive for participating is an interest rate that has been historically 100-200 bps above the regulated bank deposit rate.

Entrusted Loans: Entrusted loans allow corporates entities to lend to each other. If Corporate A wants to lend to Corporate B, they can go through a bank by using an entrusted loan structure. The bank acts purely as a book entry entity, and Corporate A will bear all credit risk from lending to Corporate B. Entrusted loans are regulated by the CBRC.

Micro lending and pawn shops: Micro lenders and pawn shops are smaller, regulated parts of shadow banking. The outstanding amount is comparatively small, and they target individuals as well as small and medium businesses (SME thereafer).

Informal Lending: This is an unregulated sector, and often used for SME lending, and they do not have financial institutions acting as intermediaries or as book entry entities.

shadow banking

  • Causes of Shadow Banking expansion

The shadow banking has grown fast since 2009, when the Great Financial Crisis decreased significantly Chinese local governments revenues through lower economic activity. In addition, these governments reduced corporate taxes to preserve companies from bankruptcy and ensure to maintain labor force employed.

As a result, local government had to find a way to get money to conduct investment projects in infrastructure and sometimes cover their expenditures. Local Government Financing Vehicles (LGFVs) have been part of the answer: since it is forbidden for local government to get loans directly from banks, trust are used to overcome this constraint. Trust act like an intermediary, borrowing from banks and lending to local governments. The trick is that trusts have to pay interests to the bank thus charging an even higher interest rate to the local governments and triggering a debt build-up.

Wealth Management Products (WMPs) are structured by securities companies (Guotai, Haitong…) and sold by traditional commercial banks (ICBC, ABC….). These products are risky and can be compared to subprime products responsible of the 2008 financial crisis in the US. They are usually invested in dubious projects and it is often difficult to evaluate risk since product composition is at best unclear.

WMPs mainly rely on interbank market to exist and enable companies to get financing when traditional loans are unavailable. This is particularly acute in sectors to which lending has been curtailed, such as industries in overcapacity (i.e.: steel, real estate…). Still, this financial products attracts private investors looking for better yield than traditional low deposit rate, and their opacity regarding actual risks, coupled with widely held beliefs that loans will be reimbursed and banks bailed out in case of a crisis, is a potential explosive situation.

Fitch-China-new-financing+2-3 trilion RMB of new credit per year since 2009

Gradual reforms

Reforms are going to be gradual. Chinese leaders have always be cautious when implementing reforms, partly because they are afraid of failures and side effects. As social stability remains a key concern, the government prefers to move step-by-step with caution.  However, although gradual reforms are not a problem generally speaking, in China time is limited right now and the risks are growing rapidly with fast increases in credit, dubious exposures from the shadow banking sector, and overcapacity in many industries.

The situation may soon turn to be out of control without any major actions. As this article shows, Shanxi Zhenfu Energy Group, a coal miner is going to default, meaning the trust is not going to be paid. ICBC doesn’t want to pay investors since the trust is not going to pay.

There should be no mystery why this investment, known as “2010 China Credit-Credit Equals Gold #1 Collective Trust Product,” is on the verge of default.  China Credit Trust loaned the proceeds from sales of the 3.03 billion-yuan ($496.2 million) product to unlisted Shanxi Zhenfu Energy Group, a coal miner.  The coal company probably is paying something like 12% for the money because Credit Equals Gold promised a 10% annual return to investors—more than three times current bank deposit rates—and China Credit Trust undoubtedly took a hefty cut of the interest.

Shanxi Zhengfu Energy Group is not alarming by itself. Problem is, in China there are a lot of Shanxi Zhengfu Energy Group.  Here the government is stuck. If it let the default to occur, it might trigger a financial crisis due to loss of confidence and cross-borrowing. If the government step in and bailout, it will send the signal that the implicit guarantee is going to continue to play a major role so investors, institutions can take whatever risks and bet since the government is the one who really bear the risk. According to Bloomberg, 2.6 trillion yuan ($427 billion) of interest and principal on securities issued by non-financial companies must be repaid in 2014. It’s 19% more than in 2013. A weaker economy coupled with over-capacity sectors (steel, iron ore, shipbuilders…) will increase default risks.


The new Chinese leadership announced a bold reform agenda late last year, which should help re-balance the economy away from investments and towards more households consumption. The optimists suggest that this transition will be smooth and ensure strong economic growth for years to come.

There are however grave doubts regarding the ability of the Chinese government to ensure steady growth around 7% during the transition period. Since half of current Chinese GDP growth relies on investment, it is obvious that any decrease in investment would significantly damage GDP. The government is thus facing a tradeoff between reforms, growth and employment.

Implicit guarantees have to be removed in order for the market and investors to price risks at there real value. As long as PBOC and the Chinese government step in and bailout failed institutions, risks will continue to increase until it become impossible for them to bailout anyone any more.

On January 27th, a solution has been found to avoid default from Shanxi Zhenfu Energy Group. According to some source, the Shanxi local government and Huarong Asset management will step in to pay back final investors. Details such as principal and interest or just principal need to be clarify. A mega default has been avoided at a terrible price. Too big to fail is still taking place in China.

Investors may now be subject to moral hazard, the expectation that the Chinese government will step in to avoid a default, increasing their incentives to take more risks instead of reducing them. Tensions are thus not going to ease in China at least in near and medium term. As Yao Wei, a Hong Kong-based China economist at Societe Generale SA. said to Bloomberg, “If a financial market doesn’t even allow defaults, how can there be real market-based interest rates?”. The government decision to avoid a default is not compatible in the long-run with the interest liberalization policy. This decision only delay or even amplify the problem in the future. Although absence of default is now a major market distortion, we don’t think major reforms regarding interest rate liberalization or reforms regarding the banking system will take place in 2014. Instead, we think the government will implement “light reforms” to show its willingness to go forward and do whatever it takes to avoid heavy stress within the financial and banking system including bailout, liquidity injection. Therefore, the probability that China reaches its Minsky moment keep increasing. One should remember that the government ability to fight severe macroeconomic shocks has limits.

To conclude, for those who are interested to bet against China in 2014 some options might be considered. Mining contributed 50% of Australian GDP growth in 2012 and is expected to slow sharply. Australian banks are highly exposed to this sector. Therefore,  Australian banks seem to be a reasonable target. For instance, Commonwealth Bank is also the most expensive bank in Australia and probably the most shortable.

China property developers also appear to be a good bet, especially given the risks to the bursting of the investment bubble. State-owned China Resources Land seems to be holding a substantial risk. However, some have projects abroad, in Australia for instance, might help them in the future.

Mining companies such as the Australian iron-ore miner Fortescue Metals will also suffer greatly, with iron ore and steel highly vulnerable to a China slow down in investment. Fortescue has a high leverage and is therefore probably the best short in the iron ore space. Finally, weak Australian banks and mining sector would both negatively impact the Aussie dollar.

Written by Maverick

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.